Do you know what a customer is worth?
Quick, what is a customer worth to you?
If you couldn’t answer that question, you’re not alone. Few small business owners can.
But, you need to be able to answer that question.
It’s one of the most important metrics in your business.
The metric is “customer lifetime value” (CLV). It tells you what a customer is worth to you over the life of your relationship.
This number is critical to your marketing efforts because it defines how much you can spend on marketing and advertising. It’s also a useful number to gauge the viability of your business.
First, I’ll explain how to calculate it. Then, I’ll get into the things you can do with it.
How do you calculate the CLV?
The CLV is the total gross margin you will earn from a customer. Gross margin is the money they pay you minus the cost to you of what they purchased.
Your first decision when calculating the CLV is exactly how long is a lifetime?
This will depend on what you sell. It could be as short as a single transaction or as long as an actual lifetime. If your customer relationships span many years, you may want to simplify things by setting a duration for planning purposes. Popular choices are a quarter or a year, depending on your planning cycle.
The simplest case is when your typical customer makes a single purchase, or their purchases are many years apart. Then you can use the value of that single purchase as the CLV.
For example, let’s say you’re a wedding photographer who charges $2,000 for a wedding. It takes 5 hours of labor that costs you $750. Since this is likely a one-time purchase, your CLV = $2,000 – $750, or $1,250.
Another common situation is a monthly subscription. Your CLV would be the total gross margin collected over the average life of a subscription.
Let’s say you sold a monthly subscription for $99 per month and expected an average customer to stay for 6 months. The total sale would be 6*$99, or $594. Your cost to deliver the subscription is $20 per month, or $120 over the life of the subscription. The CLV = $594 – $120, or $474.
The hardest scenario is when you have a long-term relationship, but each transaction is independent of the others. This is the case for any business that has repeat customers.
To come up with a simple estimate, do this. Divide your gross margin by the total number of customers you had in the length of time you decided on. So, if your gross margin last year was $500,000 and you sold to 1,000 individual customers during the year, the CLV is $500.
There are more complex ways to calculate CLV for this case. As a start, the simple method above will do.
What should you do with the CLV?
First, the CLV will tell you if you have a viable business. Here’s how.
Let’s say you expect your CLV for a new venture to be $1,000. You’ve also determined that your average cost per acquisition (CPA – more on this next week) is likely to be $300. Finally, you expect your operating costs for the first year to be $150,000.
The first thing we can figure out is the number of customers do we need to break even.
Breakeven volume = operating cost / (CLV – CPA)
In our example, that works out to 215 customers.
That means, given the value and costs we assumed, you will need to have at least 215 in the first year to break even. Compare that number to reasonable estimates of how many customers you think you can get.
Now you know if you have a viable business at the value and cost levels you assumed.
The other important use of the CLV is to be the basis for calculating the critical marketing metrics I’m going to talk about next week.